If you report under IFRS, there are some important changes you need to be aware of.
If your business has to report under IFRS, or has a parent company adopting international accounting standards, there are some important changes to the treatment of operating leases that may affect your financial reporting.
In this blog we explain the impact of this new treatment on your business and its financial accounts.
The changes came into effect on the 1 January 2019, meaning that it is highly likely the first time the regulations will be applied to year end accounts will be the upcoming year end of 31 December 2019, and thereafter.
Previously, operating leases only impacted the profit and loss account, with lease payment going through the profit and loss account (and no relating asset or liability in respect of future benefits and commitments included on the balance sheet). This will change.
What is changing?
Operating leases will now have to be capitalised with both the asset and liability being brought onto the balance sheet. This change excludes short term leases (12 months or less) and low value assets (such as laptops and telephones) as implementing IFRS 16 for these assets will not improve the quality of information.
How will I initially record the lease?
At the start, the lease will be recognised as a ‘right of use’ asset. The liability will also be recorded, being the discounted payments required to fulfil the lease (the discounted value will reflect the present value of the future payments). The initial recognition value for the asset will be valued at the same amount as the discounted lease liability.
What is the ongoing treatment?
As time passes, the asset will be amortised over the term of the lease. This is the same treatment as that for any other tangible assets recorded on the balance sheet.
Simultaneously, the liability will be reduced by the payments made as per the lease agreement.
There will also be a charge passed through the profit and loss account in respect of the unwinding of the discount applied when initially recognising the lease.
The fallout from this treatment is that your business will see the value of the asset reducing at a quicker rate when compared to the liability which in turn will lead to a reduced equity level. The charge through the profit and loss account, in respect of the discount, will be greater at the start of the lease term due to the interest charged (in respect of a higher outstanding liability) even though the cash payments will be constant.
What other impacts will there be?
While businesses will have to undertake additional work in calculating the appropriate balances to be included in their accounts in respect of the leases, as discussed above, additional side effects from this change in the recording will include a shift in results of financial ratios used. Affected ratios include debt-equity and performance ratios so this is something you will need to watch out when completing any additional reporting and comparing results to prior years!